Suggested Solutions for Tutorial 4

Suggested Solutions for Tutorial 4 - 1 Suggested Solutions...

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1 Suggested Solutions for Tutorial 4 Please note that following suggested solutions are only very basic points and you need to read the textbook and other reference materials for better understanding. 2. Within the macroeconomic context of interest rate determination there are three distinct effects of a change in monetary policy. Explain and give examples of each of the three effects. Liquidity effect: the monetary policy actions of the central bank that impact upon interest rates, particularly the overnight cash rate central bank buys or sells government securities in order to affect the money supply and the level of liquidity in the financial system if the central bank buys securities from the financial system then there will be more cash in the system and interest rates will fall; an easing of liquidity if the central bank sells securities into the financial system there will be less cash in the system as the investors pay cash to buy the securities and interest rates will rise; a tightening of liquidity Income effect: refers to the flow-on effect from the initial liquidity impact on interest rates using the example of the central bank tightening liquidity and increasing interest rates in order to reduce the levels of spending in the economy reduced levels of spending will result in lower incomes in all sectors of the economy: the household sector, the business sector and the government sector this occurs as employment growth contracts, demand for goods and services eases, and taxation revenues to government decline as the rate of growth in economic activity slows, the demand for loans also slows the slowing in the demand for funds results in an easing in interest rates. Inflation effect: in so far as the economy was previously experiencing inflationary pressures due to high levels of demand, now the slowing of the pace of economic activity will cause the rate of inflation to ease this easing allows rates of interest to ease as well the nominal rate of interest is said to comprise two components, being the real rate of return plus compensation for the expected rate of inflation if the rate of inflation is expected to fall, then market interest rates should fall 4. The financial markets often use the loanable funds approach when forecasting interest rates. Describe the concept of the loanable funds approach to interest rate determination. In your answer identify and explain the elements that comprise the supply of, and the demand for, loanable funds. loanable funds approach—the rate of interest is determined by the supply of and the demand for loanable funds loanable funds are the flows of funds into the market for securities
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2 Demand for loanable funds: There are two principal components: business demand for funds—to finance its liquidity and capital investment requirements. The
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Suggested Solutions for Tutorial 4 - 1 Suggested Solutions...

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